Emerging markets debt has had a strong and almost uninterrupted rally this year, bringing gains for dollar-denominated bonds to 9% through the end of August and 15% for local currency debt. Now, as we enter a new period of monetary policy in developed markets characterized by the withdrawal of liquidity by central banks, investors are questioning if EM debt will maintain its momentum.

In September, the Federal Reserve announced that it will soon begin winding down the asset-purchase program it began in the wake of the financial crisis in 2007. The Bank of England and the European Central Bank have also signaled their intent to roll back their quantitative easing programs. The Fed has also left open the possibility of raising its target rate again in December in what would be the fifth hike in this tightening cycle.

Even as the Fed lifts short-term rates, our fixed income team expects long-term U.S. interest rates to remain range-bound in the 2% to 2.75% range. Inflation has remained muted and the higher yields in the U.S. relative to Europe and Japan, underpin demand for Treasuries. While financial conditions overall are likely to become less accommodative, improving global economies and low benchmark Treasury yields provide a favorable backdrop for emerging markets.

More importantly, emerging markets fundamentals remain broadly positive: most have sustainable current account balances and a positive GDP growth cycle. Inflation rates are moving closer to targets, many central banks are cutting rates and currencies are fairly valued or undervalued versus the U.S. dollar.

Opportunity in EM Debt

The commodities cycle remains supportive. Even though crude oil has declined, base and industrial commodities have maintained ground. China’s economy, which has a strong influence on commodities and emerging markets, continues to grow at a steady pace, although the risks of a credit event cannot be entirely ruled out. These positive dynamics, and the significantly higher yields of emerging markets, have sustained demand from investors over the past year and will likely continue to do so.

That said, emerging markets debt still remains a higher risk asset class and is susceptible to selloffs in periods of elevated market stress or geopolitical risk. Moreover, when financial conditions tighten, most fixed income assets are susceptible to a widening of spreads to Treasuries, and emerging markets are no exception. Nevertheless, with a yield in the range of 6% to 7%, the carry (the income accrual from bonds) is high enough to offset some spread widening within a relatively short period. I would view any sharp selloff as a buying opportunity of selective credits.

Prefer Local Currency Bonds

In our global bond portfolios, we maintain a meaningful allocation to emerging markets bonds. Global bond portfolios generally tilt toward higher quality credits while dedicated emerging markets strategies straddle a broader universe of dollar and local currency sovereign debt and EM corporate bonds. In the current environment of high valuations, I favor markets that are more mature with economies that are on a positive growth trajectory. These include Mexico, Poland, the Czech Republic, Malaysia, Israel, Thailand, India, Colombia and Chile. I also prefer local currency bonds to dollar-denominated debt, which remains expensive.

From a longer term perspective, my view is that many developing economies need to implement deeper structural reforms to put their economies on a more sustainable growth path. These include greater labor market flexibility, pension reform to address fiscal deficits and clearer rules on land ownership and intellectual property. These measures will enable emerging market debt to deepen its investor base and be viewed as more of a core asset class within bond portfolios. Those economies that are more pro-actively implementing structural changes will be recognized by investors and we will likely see greater differentiation among credits.

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